from the maybe-banks-are-on-to-something dept

We've discussed peer-to-peer lending sites in the past, though mostly with respect to regulatory questions revolving around their attempts to securitize the loans. However, every time we mention those sites, we get comments or emails from people insisting that such sites are terrible and much riskier than they make out. Right after the economy crashed back in 2008 the various P2P lenders all stepped up their PR campaigns, claiming that such P2P lending could step in and provide credit where the banks were pulling back. Of course, now reports are starting to come out suggesting that, indeed, peer to peer lending is incredibly risky with extremely high default rates:

To look at the results of Prosper's loan marketplace, though, is to see not a solution to the credit crisis, but a microcosm of it. Loans to unqualified borrowers; reliance on mathematical models that turn out to be a lot less useful than they seemed; failed hopes that high interest rates could make subprime loans profitable; sky high default rates--Prosper has it all. Prosper's Web site advertises returns of 6 percent to 14 percent for lenders. But the reality is that the lenders who loaned $188 million through Prosper have not earned anything like these returns. On the contrary, the majority of them have lost money, as they've watched their loans go bad at shockingly high rates.

Much like the loans made by banks during the mortgage boom, Prosper's loans have gone into default at rates much worse than predicted by historical credit data. In November, 2007, Larsen told the Associated Press that Prosper's default rate "hovered at around 2.7%." That, however, included many new loans that simply hadn't had time to go bad. Larsen refers to this obliquely in the AP story, noting that as more loans matured the rate would rise, but there's no hint of just how steep that rise would be. Prosper's data now shows that now shows that close to 36% of the loans made before Nov. 27, 2007--the date of the AP story--have ended in default, roughly thirteen times what a casual reader would have thought from Larsen's comments. That is close, coincidentally, to the total 39% (or roughly two in five) default for the Prosper loans that have reached the end of their three year term.

The article goes on to highlight more and more ugly looking data concerning these sorts of loans -- noting that for those who try to counter the high default rate with higher interest rates, the default rate goes up sharply. This is not a surprise -- it's basically how it should be based on your typical risk/reward tradeoff -- but when the default rate on certain types of loans is over 50%, that's not exactly a reliable investment strategy.

And from there, the article highlights how Prosper appears to mislead potential lenders with some sleight of hand:

In other words, only by cutting out more than two-thirds of its loans, does Prosper manage to eke out the positive results for AA to E rated loans that prospective lenders see on Prosper.com. Or you can look at it another way and ask how many investors have actually gotten returns in the 6 percent or 14 percent range that would-be lender see blazed across the Prosper.com front page? Thanks again to Eric's Credit Community, we have a pretty good idea: Of investors with a portfolio of loans that are an average of at least two years old, folks who have lost money outnumber those who've earned 6 percent annual return by more than six to one.

The article goes on and on in that vein, and it's really damning to the claims from some of these sites. Given how many articles have praised such services as potentially "revolutionizing" how people raise money for things, it's definitely worth highlighting these questionable results.

Update: A few folks are suggesting that Prosper is different than others in the space...

Disintermediation shrinks the money supply

One reason why P2P lending doesn't have anywhere near the financial impact as bank lending is because the fractional reserve system allows the banks to lend money they don't actually have, thereby creating money from nothing.

In a P2P arrangement, the peers can only loan money that they actually have. If any part of that loan goes towards paying off an existing loan, the money supply shrinks, by approximately 10 times the amount used to pay towards the bank loan. That is the fractional reserve system at work in reverse.

That, by the way, is how we can have deflation even with the government printing presses going full tilt. It's the "mattress money" phenomenon (much of the new money is going to pay off old debt, or just being held in cash, because deflation is a very powerful positive feedback cycle). When the government money creation finally does overwhelm the mattress money phenomenon, that money will go back into circulation all at once, and we will see Weimar America.

The most popular denomination of the new currency will probably be 9mm.

Ripple is still small, and still only slowly growing, but unlike prosper has the 'fractional reserve' aspect that Tx CHL Instructor noticed is lacking. But unlike prosoper if the USD ever tanks ripple users will probably still be OK.

Then again, ripple:prosper::gnutella:napster, so they are kind of different.

Or is that because Prosper is another bank?

I think there is merit in the p2p/social lending concept, however I think Prosper's method is essentially that it is behaving as a bank rather than a marketplace.

So the problem lies in emulating the poor banking practices that characterised the Financial crisis. If Prosper was more of a marketplace platform then I think the behaviour and returns would be better.

P2P lending

Well i have some different opinion in this topic. Yes p2p lending sites have high default rates that true. But you are free to lend on those you find trustworthy. And sites like http://www.yes-secure.com are do lot of underwriting work so it seems to me that you can trust p2p sites.
And from borrowers point of view, were they will get loan if banks and not providing the loans.
And, Are banks cent percent safe to invest?
well go for p2p lending with care. Good Luck!